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How to Value Stocks: Introduction to Valuation Methods

It's not just a piece of paper -- it's part ownership of a company.

Valuation is the first step toward intelligent investing. When an investor attempts to determine the worth of her shares based on the fundamentals, it helps her make informed decisions about what stocks to buy or sell. Without fundamental value, one is set adrift in a sea of random short-term price movements and gut feelings.

For years, the financial establishment has promoted the specious notion that valuation should be reserved for experts. Supposedly, only sell-side brokerage analysts have the requisite experience and intestinal fortitude to go out into the churning, swirling market and predict future prices. Valuation, however, is no arcane science that can only be practiced by MBAs and CFAs. With only basic math skills and some diligence, any Fool can determine values with the best of them.

Before you can value a share of stock, you have to have some notion of what a share of stock is. A share of stock is not some magical creation that ebbs and flows like the tide; rather, it is the concrete representation of partial ownership of a publicly traded company. If XYZ Corp. has 1 million shares of stock outstanding and you hold a single, solitary share, that means you own a millionth of the company.

Why would someone want to pay you for your millionth? There are quite a few reasons, actually. There is always going to be someone else who wants that millionth of the ownership because they want a millionth of the votes at a shareholder meeting. Although it’s small by itself, if you combine that millionth with about 500,000 of its friends, you suddenly have a controlling interest in the company. That means you can make it do all sorts of things, like pay fat dividends -- or merge with your company.

Companies buy shares in other companies for all sorts of reasons. Whether it’s an outright takeover, in which a company buys all the shares, or a joint venture, in which the company typically buys enough of another company to earn a seat on the board of directors, the stock is always on sale. The price of a stock translates into the price of the company, on sale for seven and a half hours a day, five days a week. It is this information that allows other companies, public or private, to make intelligent business decisions with clear and concise information about what another company's shares might cost them.

A share of stock is a stand-in for a share in the company's revenue, earnings, cash flow, shareholders’ equity -- you name it, the whole enchilada. For the individual investor, however, this normally means just worrying about what portion of all of those numbers you can get in dividends. A share of ownership entitles you to a share of all dividends in perpetuity. Even if the company's stock does not currently have a dividend yield, there always remains the possibility that at some point in the future there could be some sort of dividend.

However, a company can also simply repurchase its own shares using its excess cash, rather than paying out dividends to shareholders. This effectively drives up the stock price by providing a buyer, as well as improving earnings per share (EPS) comparisons by decreasing the number of shares outstanding. Mature, cash flow-positive companies tend to be much more liberal with share repurchases as opposed to dividends, simply because dividends to shareholders get taxed twice.

This series of articles will take you through the major methods for valuing companies. The main categories we'll go through are valuations based on earnings, revenue, cash flow, equity, and subscribers. With these methods under your belt, you should have a start on valuing nearly any kind of business.